Impermanent loss happens when the algorithmically-determined formula of automated market makers (AMM) in DeFi reveals a disparity between the price of an asset within and outside a liquidity pool. The AMM eliminates middlemen in decentralized exchanges and trades assets from a liquidity pool of tokens supplied by liquidity providers.
A constant algorithm formula maintains the liquidity pool by balancing the token-to-pool-size ratio. Due to the AMM calculator’s emphasis on the ratio, depreciation results in a loss for assets outside the pool.
What is impermanent loss?
Impermanent loss is the gap between your value and the value of the assets you put into a liquidity pool in place of holding your crypto assets. You have an impermanent loss if the value would have been higher if you had simply kept your crypto in your wallet rather than supporting liquidity.
An impermanent loss resembles an opportunity cost as a result. The difference between an impermanent loss and an unrealized loss in stock investing is that your initial investment in the liquidity pool is not taken into account while making the computation, unlike an unrealized loss. Instead, it contrasts the value of your liquidity pool investment with the value you would have had if you had simply retained your tokens based on the mix of tokens still in circulation.
It is conceivable to have both an impermanent loss and an unrealized gain because of how the term “impermanent loss” is calculated. The fundamental problem that can result in impermanent loss is that the quantity of tokens in the pool changes when swaps take place.
Impermanent loss can happen due to a number of factors.
- Volatile tokens: Impermanent loss happens more frequently when one of the tokens in a trading pair is more volatile than the other.
- New or thinly traded tokens: New or thinly traded tokens may not have proper price discovery or a large enough market to tempt arbitrage traders.
- Wide trading range: Impermanent loss can also occur if you allow a wider trading range. Some decentralized exchanges, like Uniswap, let you fine-tune the trading range for tokens.
- Small pools: Token prices get pushed around more easily in small liquidity pools.
How to calculate impermanent loss
Impermanent loss occurs when tokens in a liquidity pool are compared to their holding value. Token pairs in the fund should have equal total values. In order to keep an equal total value, the formula X*Y=K is used. The calculator demands that one token’s value match the value of another token in the pool. The automated price model’s basic principle is the equal value relationship.
When a trader wants to exchange A for B in a liquidity pool with 50% of token A and 50% of token B, the number of tokens A decreases while the quantity of token B increases. To preserve the value of the two tokens, the AMM algorithm would raise the price of token A relative to token B. The larger the gap between the tokens, the higher the temporary loss.
The impermanent loss of AMM liquidity pools with similar assets has been greatly minimized. Calculating impermanent losses becomes more complicated with a bigger number of liquidity suppliers. Liquidity tools in DeFi include DeFiPulse, vFat, DeFiLlama, and LiquidityFolio. DeFi Pulse and DeFiLlama are statistical methods for tracking, and vFat is a yield farming calculator. LiquidityFolio is a liquidity management solution for Uniswap investments.
Impermanent loss in crypto
Impermanent loss in crypto is virtually as substantial as it is in the stock market. DeFi service providers can mitigate impermanent loss by using staking rewards to buffer liquidity suppliers. The strategy pays liquidity providers a percentage of the platform’s trading fees.
To compensate for the loss, the protocols reward the LPs with the platform’s native tokens, which derive their value from network activity. Liquidity providers earn more in distributed fees and token rewards as volatility rises and trading activity rises.
Uniswap, a liquidity pool, has created an incentive system based on project-based tokens. Tokens can be exchanged or used in various portions of the DeFi system. Liquidity delivered to the appropriate balancer may result in token gains. Timing is key when giving liquidity since users who provide liquidity during high trading activity seasons earn a higher return than users who provide liquidity during low activity seasons.
Strategies to mitigate impermanent loss
Using stablecoin pairs
Stablecoin pairs such as USDC and USDT can be used to avoid temporary losses. Stablecoins are not prone to volatility, and the risk of temporary losses is significantly reduced. In the process, a trader can earn trading commissions. The disadvantage of providing liquidity with stablecoins is that there are no gains in a positive market. Impermanent loss is also unavoidable during moments of severe price fluctuation.
Trading fees can be used to cover temporary losses. All DeFi transactions incur trading fees, a portion of which is shared with liquidity providers. The earnings from trading fees could be sufficient to offset the short-term losses. The temporary loss decreases as the number of fees received increases.
Currency pairs used to provide liquidity are one element that may help to minimize temporary losses. Liquidity pairings are highly volatile against one another. Impermanent losses would increase if one token in a pair outperformed the other.
Some DeFi protocols have a 50/50 AMM ratio. As the pool strives to balance its worth, the ratio increases the aspect of impermanent loss. Other decentralized exchanges may have different ratios, and the exchanges may allow for the pooling of several assets.
Stablecoins could protect DeFi systems with a single-currency liquidity pool against volatility, which can lead to larger temporary losses. To avoid temporary loss, a trader should wait for the price of a pair to recover to the initial level of entry. Some AMMs may only have one currency liquidity pool rather than two.